Factors influencing choice of fixed-price

Factors influencing choice of fixed-price versus cost-plus bids

Factor Fixed-price bids Cost-plus-fee bids

Degree of cost uncertainty (and/or uncontrollability)

If costs are relatively easy to control, buyers will insist on this mode, and seller must tolerate the risk of cost variability.

If cost uncertainty is high, sellers will strongly prefer this mode, and buyers must tolerate the risk of cost variability.

Seller’s attitude to risk If highly risk-averse, the seller will not want to bid in this mode, unless required to (unless the seller can be risk-neutral due to many concurrent bids, in which case, the seller will tolerate these).

Whatever the degree of risk aversion (unless the seller is risk- neutral) the seller will prefer cost- plus bids since these push all the cost variability risk to the buyer.

Buyer’s attitude to risk If highly risk-averse, the buyer will strongly prefer this mode.

If highly risk-tolerant, the buyer will accept these, and indeed sellers will only want to bid in this mode if cost uncertainty is high.

Many trials of the same risk

If the seller routinely and repetitively bids on similar contracts, it can act as if it is risk- neutral (and submit fixed-price bids), since high-cost jobs will tend to be balanced by low-cost jobs.

If the buyer routinely and repetitively calls for similar tenders, it can act as if it is risk-neutral (and submit cost-plus-fee bids), since high-cost jobs will tend to be balanced by low-cost jobs.

Any request for tender (RFT) by a buyer will have an implicit or explicit quality expecta- tion built into the specifications of the work to be done. For example, if you ask for a quote for new tires on your car, or to fix your transmission, you expect the job to be completed to a particular level of quality. You want new tires that comply with road safety regulations, or you want your transmission to work properly again. The buyer will typically be happy enough to bear a legitimate cost over-run that is necessary to achieve that expected level of quality, even if the extra cost is unexpected. The problem is the asymmetry of infor- mation between the buyer and the seller: The buyer may not be sure that the extra costs charged by the seller are, in fact, necessary to achieve the desired level of quality. Where observation and monitoring of the project by the buyer is unsafe (as in the workshop) or would be expensive (in terms of incurred costs and opportunity costs) there needs to be a mechanism to ensure that the seller does indeed deliver the specified quality without leveraging the asymmetry of information to raise its profit at the expense of the buyer.2

2. By seeking multiple quotes, and more detail from each potential seller, the buyer is likely to reduce the information asymmetry by gaining more information about the production side of the job, including what the job is most likely to involve and what is likely to be the costs of labor, materials, parts, and so on.

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CHAPTER 10Section 10.1 Types of Competitive Bids and Price Quotes

The third type of competitive bid provides one such mechanism. It is known as incentive bid pricing, and involves the buyer and seller agreeing on the bid price initially, but also agreeing to share any deviation from the expected cost in an agreed proportion. The vari- ance of actual costs from the expected costs is a cost over-run (if positive) or a cost under- run (if negative). For example, the share of the cost variance might be agreed to be 50% to each party, or in another case 70:30, with one party taking the larger proportion. In these situations, the seller has a substantial incentive to control costs, since it will have to pay a proportion of any cost over-run and this will reduce its profit from the job. Conversely, any cost under-run will also add to its profit because the seller will receive an agreed portion of that cost saving. The buyer’s incentive to pay more, to cover unexpected cost increases, is to achieve the desired level of quality associated with the job. On the other hand, if the repair is not as extensive as anticipated, or if weather and other uncontrollable factors play nicely, both the buyer and the seller benefit from the unexpected cost savings.

Apart from price and quality, the third major issue with competitive tenders is time to completion. Project management of a competitive bid transaction involves the efficient management of costs, quality, and the time it takes to complete the project. The buyer will typically want to set a deadline by which time the job is to be completed, and this deadline will usually be part of the tender specifications. Especially when the project is consid- ered to be urgent, such as completing major road works, bridges, and other public infra- structure (for B2G contracts); completing the manufacture and installation of new capital equipment to allow a business to get back in business (for B2B contracts); or completing a car repair or house renovation (for B2C contracts), the tender specifications might include a clause relating to penalties for late completion, and, conversely, for bonuses if the project is completed before the deadline. Note that such agreements are effectively risk sharing agreements as well, since production delays might be caused by both controllable factors (such as poor management by the seller) and uncontrollable factors such as bad weather and unavoidable delays in receiving materials. If the seller beats the deadline it receives a bonus for early completion, and indeed it may have put in place an incentive contract

with its own managers and employees to share this bonus with them if the contract is com- pleted prior to the deadline. The buyer will be happy to pay this bonus because it will allow early access to the completed project and the bonus will be less than the opportunity cost associated with waiting for the job to be completed. On the other hand, if completion of the project is delayed beyond the planned delivery date, the seller’s profit will be reduced to the extent of the penalties imposed and the buyer’s opportunity costs will be offset to some degree.

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Project management of a competitive bid transaction involves the efficient management of costs, quality, and the time it takes to complete the project.


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